19 th, September, Kwality Ltd. On Strong Profitability Growth Path

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1 19 th, September, 2016 Kwality Ltd On Strong Profitability Growth Path

2 15-Sep Oct Oct Nov Dec Dec Jan Feb Mar Mar Apr May May Jun Jul Jul Aug Sep-16 Initiating Coverage Recommendation CMP (Rs.) Target Price (Rs.) BUY Rs.120 Rs.150 (Upside 25%) Snapshot: Kwality is one of the largest manufacturer of milk & milk products in the private dairy sector in India with processing capacity of over 3.2 mn litres/day. With its diverse product portfolio, comprising of milk powder and fresh milk products, the company caters to customers Stock Details under its Kwality and Dairy Best brand. Recently, the company won legal battle of Kwality brand. BSE Code INVESTMENT RATIONALE Bloomberg Code KWALITY IN Market Cap (Rs. cr) Free Float (%) 52- wk HI/Lo (Rs) / 68 Building consumer-focused dairy products company: Kwality is transforming rapidly from a traditional B2B dairy player to a consumeroriented branded products company. At present, the company derives 68 per cent revenues from institutional segment and balance from retail Avg. Volume (Monthly) segment. Over the next three years, the company intends to increase consumer business from the present 32 per cent to 70 per cent on the Face Value (Re) 1 back of capacity expansion, widening product portfolio including valueadded Dividend (%) (FY 16) Shares o/s (Crs) products (VAP) like flavored milk, paneer, cheese, and butter, among others, brand building and increasing distribution reach. Relative Performance 1Mth 3Mth 6Mth 1Yr KWALITY IN (%) SENSEX (%) Kwality Ltd Shareholding Pattern as on 30 th June, 2016 Promoters Holding 64.9 FIIs 0.3 DIIs - Public & others 34.8 Manish Ostwal Sr. Research Analyst ( ) id: manish.ostwal@nirmalbang.com Sensex Enhanced focus on VAP to expand EBITDA margin sharply: Kwality reported gross profit margin and EBITDA margin at 9.4 per cent and 6.1 per cent respectively in FY16, mirroring product mix (liquid milk revenue at 53 per cent) and business mix. We believe product mix shift towards VAP with higher realizations coupled with B2C business model will expand EBITDA margin (8-9 per cent) over long term. However, increase in brand building cost will offset gross margin expansion in the short-run. Free cash flows to aid deleveraging: Kwality has been reporting negative operating cash flows / free-cash flows over the last two years. This has also resulted into increase in debt from Rs crore in FY14 to Rs crore in FY16. Interest expense as percentage of EBITDA has remained at elevated levels (40 per cent) during the same period. Now, the company is entering into higher free-cash flows period aided by EBITDA margin expansion and reduction in working capital cycle. Valuation & Recommendation: Business model transformation, expansion in EBIDTA margin, decline in working capital cycle and deleveraging are key value drivers for re-rating in the stock. We estimate Kwality to clock 23 per cent CAGR in net earnings over FY16-FY19, among the best in dairy sector. RoCE will improve significantly from 18.5 per cent in FY16 to 24.3 per cent in FY19, largely attributable to margin expansion. With strong free cash flows and debt repayment, the stock is set to re-rate over the medium term. We value the company at 10x FY18 EBITDA to derive a price target of Rs150. We recommend BUY on the stock with a price target of Rs150 over the next 9-12 months. Particulars (Rs Cr) Net Sales Growth (%) EBITDA PAT EPS (Rs) P/E (x) FY' % FY'17E % FY'18E % FY'19E % P a g e

3 BUSINESS MODEL ANALYSIS Kwality is a dairy company with over 3.2 million liters milk processing capacity with high concentration towards institutional segment. Over the years, the company has established strong presence in India s largest production and consumption markets i.e. Rajasthan, Haryana, UP and Punjab. Over the last three years, the company has enhanced its focus towards retail business and increasing procurement directly from farmers. In FY16, the company derived 32 per cent of its revenues from retail segment compared to 25 per cent in FY14. As far as milk procurement is concerned, the company procured over ~ 20 per cent of its daily requirement from farmers directly in FY16 against 14 per cent in FY14. We believe sustainable superior profitability in dairy sector is dependent upon three critical success factors, namely, direct procurement mix, robust product portfolio and retail / branded product business mix. Kwality is moving from traditional B2B business model to B2C business model with strong focus on direct milk procurement infrastructure, high-margin branded value-added products and brand building. This will improve business profitability, reduce working capital and strong free-cash flow generation on consistent basis. Exhibit 1: Transforming business model from B2B to B2C with strong focus on value-added products Current Business model Direct milk procurement ~ 18% Business mix between institutional and retail segment stands at 70 per cent and 30 per cent respectively Small product portfolio with no major value added products contribution EBITDA margin at 6 per cent Stretched working capital cycle Negative operating cash flows / freecash flows Strategic changes to Business Model Increase direct milk procurement to 50% over the next three years Retail business mix to increase from current 30 per cent to 70 per cent over the next three years. Capacity expansion in value-added product categories and rolling out various valueadded branded products EBITDA margin to increase from 6 per cent in FY16 to 9 per cent in FY19 on the back of higher revenues from high-margin valueadded products. Shift towards B2C to improve working capital cycle and support deleveraging Generating higher free cash flows Source: Nirmal Bang PCG Research 3 P a g e

4 INVESTMENT RATIONALE Building consumer-focused dairy products company Kwality is transforming rapidly from a traditional B2B dairy player to a consumer-oriented branded products company. Presently, the company derives 68 per cent revenues from institutional segment and balance from retail segment. Over the next three years, the company intends to increase consumer business from the present 32 per cent to 70 per cent on the back of capacity expansion, widening product portfolio including value-added products (VAP) like flavored milk, paneer, cheese, butter, among others, brand building and increasing distribution reach. We believe sustainable and profitable growth in dairy business depends upon three important areas, namely, milk procurement model, robust product portfolio and retail / branded product business mix. The company is setting up a new plant (mainly focusing on value-added products) with total CAPEX of Rs. 400 ccrore along with Rs. 120 crore towards building milk procurement infrastructure. Post this expansion, the company will increase direct milk procurement mix from current 20 per cent to 50 per cent over the next three years. This will ensure consistent and quality milk availability for value-added products manufacturing. After reaching certain scale in dairy business (processing 3.2 mn liters milk per day), the company is now adding products like flavored milk, UHT, milk sweets, cheese, yoghurts, table butter into the product portfolio coupled with increasing sales to consumer segment. Exhibit 2: Revenue growth 7500 Operating revenues Exhibit 3: Business mix tilt to consumer Biz 120% Institutional business Retail Business 100% 20% 29% 32% 80% 41% 51% 60% 70% % 20% 80% 71% 68% 59% 49% 30% 4000 FY14 FY15 FY16 FY17E FY18E FY19E Source: Company, Nirmal Bang PCG Research 0% FY14 FY15 FY16 FY17E FY18E FY19E To increase consumer business, the company has come out with a strong product pipeline of value-added products under KWALITY mother brand architecture with leading Bollywood actor Akshay Kumar as the brand ambassador. The targeted high milk consuming markets like Delhi, UP, Haryana and Rajasthan coupled with new and fresh dairy products will drive revenue growth, expansion in gross profit margin & EBITDA margin and substantial reduction in overall working capital requirement over the next few years. 4 P a g e

5 The company has engaged marketing partners for roll-out integrated marketing strategy for value-added and youth dairy products over the next few years. Marketing partners include McCANN & Cheil India for creative, Zenith Optimedia for media planning and digital Quotient in digital space. We believe business model moving from low margin business / B2B segments to value-added high margin business / B2C segment over the next three years which will help to deliver structural EBITDA margin expansion. Enhanced focus on VAP to expand EBITDA margin sharply Kwality reported gross profit margin and EBITDA margin at 9.4 per cent and 6.1 per cent respectively in FY16, mirroring product mix (liquid milk revenue at 53 per cent) and business mix. We believe product mix shift towards VAP with higher realizations coupled with B2C business model will expand EBITDA margin (8-9 per cent) over long term. However, increase in brand building cost will offset gross margin expansion in short-term. The company is spending ~ Rs. 120 crore for building robust direct milk procurement infrastructure like setting up milk chilling centers and controlled temperature vehicles. The company will also begin farmers connect program at a large scale to help better cattle feeds and higher yields from cattle. Post capacity expansion, the company will process over 4 mn litres milk in at its manufacturing facilities. Broadly, product portfolio is divided into three categories like lower margin products (4-5 per cent EBITDA margin, mid margin products (9-10 per cent EBITDA margin) and high margin products (20 per cent EBITDA margin). New capacity will help to attain value-added high margin products revenue close to ~ Rs crore - Rs crore into the consolidated net sales by FY19. Exhibit 4: Drivers of EBITDA expansion Categories EBITDA Low margin products 4-5% Mid-margin products 9-10% High-margin products 20% plus FY16 Revenues EBITDA margin 6.1% Rev from high-margin products - FY Consolidated Revenue -FY EBIDTA expansion - VAP (in bps) 300 FY19 EBITDA margin 8.9% Source: Company, Nirmal Bang PCG Research Exhibit 5: Gross margin & EBITDA trend Gross profit margin EBITDA margin 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% FY14 FY15 FY16 FY17E FY18E FY19E We expect EBITDA margin to increase from 6.1 per cent in FY16 to 8.9 per cent in FY19 aided by high-margin value added products revenue and change in business segment mix from B2B to B2C. We believe structural drivers for gross profit margin & EBITDA margin coupled with change in business model will sustain improved profitability (9 per cent-10 per cent EBITDA margin) over long term. 5 P a g e

6 Free cash flows to aid deleveraging The Company has been reporting negative operating cash flows and free-cash flows over the last two years. This has also resulted into increase in debt from Rs crore in FY14 to Rs crore in FY16. Interest expense as percentage of EBITDA has remained at elevated levels (40 per cent) during the same period. Now, the company is entering into higher free-cash flows phase aided by EBITDA margin expansion and reduction in working capital cycle. Core working capital cycle will reduce from 101days in FY16 to 82days in FY19, leading strong growth in free-cash flows. The company will use free-cash flows to reduce balance sheet leverage. Debt to equity ratio will decline from 1.7x in FY16 to 0.5x FY19 driven by ~ Rs. 745 crore debt repayment over FY17-FY19. Consequently, interest expense / EBITDA ratio to fall sharply from 41 per cent in FY16 to 20.8 per cent in FY19, driving net profit growth. Exhibit 6: Reduction in debts Rs in crore FY14 FY15 FY16 FY17E FY18E FY19E Core working capital cycle (in days) Operating cash flows Free cash flows Gross debt D/E Interest / EBITDA 39.4% 40.1% 40.5% 38.5% 31.6% 20.8% Source: Company, Nirmal Bang PCG Research Superlative net earnings growth and sustained higher return on equity Net profit grew 9.4 per cent CAGR to Rs crore over FY14-FY16 aided by 15.1 per cent growth in EBIDTA offset higher interest expense. We believe new capacity led revenue growth, EBIDTA expansion and debt repayment will drive net earnings over the next few years. We expect the company to deliver 23 per cent CAGR in net earnings over FY16-FY19, among the best in dairy sector. Superlative net earnings growth and balance sheet deleveraging will expand RoCE from 18.5 per cent in FY16 to 24.3 per cent in FY19. We believe strong earnings growth coupled with improving RoCEs would lead to re-rating over the medium term. Exhibit 7: Net profit Exhibit 8: RoCE 30.0% % 24.3% % 15.0% 10.0% 20.6% 19.6% 18.5% 16.7% 17.8% FY14 FY15 FY16 FY17E FY18E FY19E Source: Company, Nirmal Bang PCG Research 5.0% 0.0% FY14 FY15 FY16 FY17E FY18E FY19E 6 P a g e

7 RISKS & CONCERNS Availability and price volatility of raw milk Kwality s business depends on its ability to procure sufficient good quality raw milk at commercially viable prices. Though the company has long-standing relationship with milk farmers and milk contractors, it has not entered into any formal supply agreements. In the event Kwality is unable to increase the supply of raw milk at reasonable prices or at all, or even maintain current milk supplies due to increasing competition, its growth may get impacted. The company is looking to increase direct procurement mix from current 20 per cent to 50 per cent over the next five years. Increased price intensity among private dairy players Entry of large corporate groups like Godrej, Mahindra and ITC into the dairy sector coupled with aggressive growth plans of co-operative dairies (Amul / Mother Dairy) may impact dairy product prices adversely especially in value-added product segment which in turn impact profitability. Kwality s brand focus strategy and faster product portfolio rollout would mitigate these risks to large extent. 7 P a g e

8 VALUATION AND RECOMMENDATION Business model transformation, expansion in EBIDTA margin, lower working capital cycle and de-leveraging are key value drivers for re-rating in the stock. We estimate Kwality to clock 23 per cent CAGR in PAT over FY16- FY19, among the best in the dairy sector. RoCE will improve significantly from 18.5% in FY16 to 24.3% in FY19 largely attributable to margin expansion. Kwality s success is largely dependent upon disciplined execution of product expansion and branding & distribution strategies. Strategic resets in milk procurement model, product portfolio and business mix are steps in the right direction. At Rs120, the stock is trading at 9.9x FY17 EV/EBITDA and 8.1x FY18 EV/EBITDA, a 40 per cent discount to peers. Negative free cash flows and balance sheet leverage are primary factors for such a high valuation discount. With strong free cash flows and debt repayment, the stock is set to re-rate over the medium term. We value the company at 10x FY18 EBITDA to derive a price target of Rs150. We recommend BUY on the stock with a price target of Rs150 over the next 9-12 months. Key risk to our view are sharp rise in milk procurement price & skimmed milk price and price wars among dairy players. Exhibit 9: Peer comparison and Relative Valuation INR CRORE Hatsun Agro Heritage Foods Kwality Parag Milk Foods Prabhat M cap Net debt EV EV/EBITDA Asset turn Gross profit margin 27.7% 21.1% 9.4% 25.1% 22.3% EBITDA margin 8.8% 5.5% 6.1% 8.7% 10.2% RoCE 24.6% 26.2% 22.7% 19.5% 10.3% PE (x) Working capital days Source: Companies, Nirmal Bang PCG Research 8 P a g e

9 COMPANY BACKGROUND Kwality Ltd. is one of the largest processor of dairy products in the private sector in India. The company was incorporated in 1992 as backward integration unit of Kwality Ice Creams and acquired by the present promoters in Presently, the company has processing capacity of 3.2 million litres of milk per day with six milk processing units across Rajasthan, Haryana and UP. Presently, the company is procuring ~ 20 per cent of milk requirement directly from more than 3,00,000 farmers spread across 4500 villages through 22 milk collection centres (MCCs). The company sells its dairy product under Dairy Best brand. Kwality has successfully come out of a branding-related legal dispute after Graviss Holding withdrew its case on May 31, The company is also having a wholly-owned subsidiary (KDPF) in Dubai as a trading arm. Dubai subsidiary imports dairy products from India, Australia, New Zealand and Eastern European countries and sells products, both domestically and export to Middle East, Bangladesh, China, Thailand and Africa. The Dubai subsidiary contributed Rs. 690 crore to the topline and Rs crore to PAT at consolidated level in FY16. The company reported operating revenues, EBIDTA and consolidated PAT of Rs crore, Rs389 crore and PAT Rs crore respectively in FY16. Out of consolidated sales, the company derives ~ Rs4370 crore from the manufacturing operation and balance as trading turnover in India and Dubai business. Traditionally, the company s primary focus is B2B segment rather than retail consumer segment. With capacity expansion in value added products along with increase in distribution reach in target markets will see higher growth retail business mix over the next 3-4 years. The promoter (Mr. Sanjay Dhingra ) holds 64.95% stake in the company. Recently, the company announced that it will raise Rs. 60 crore from the Bennett Coleman in a preferential allotment. Apart from this, the company has received capital commitment amounting to Rs. 520 crore under structured finance from KKR PE in July Exhibit 10: Revenue split FY2016 Revenue Break up - FY16 Exhibit 11: Gross margin & EBITDA trend 10.0% Profitability 8.0% 6.0% 4.0% 2.0% 0.0% FY14 FY15 FY16 Domestic manufacturing sales Domestic trading sales Dubai trading sales Source: Company, Nirmal Bang PCG Research Gross profit margin EBITDA margin 9 P a g e

10 Exhibit 12: Business snapshot Sales (Rs. crore) EBITDA (Rs. crore) Direct procurement farmers Processing capacity (mn kg) Source: Company Note: Above financial are standalone basis. 10 P a g e

11 FINANCIALS INR CRORE FY15 FY16 FY17E FY18E FY19E INR CRORE FY15 FY16 FY17E FY18E FY19E INCOME STATEMENT CASH FLOW STATEMENT Operating revenues EBITDA Gross profit Operating cash flows before WC adjustment Employee expense Working capital changes Other operating expense Tax paid EBITDA Operating cash flow activities Other income CAPEX Depreciation Free cash flows EBIT Cash flows from investing activities Interest Cash flows from financing activities Profit before tax Change in cash Tax expense Opening cash balance PAT Closing balannce INR CRORE FY15 FY16 FY17E FY18E FY19E RATIO ANALYSIS FY15 FY16 FY17E FY18E FY19E BALANCE SHEET Growth Equity share capital Net sales 17.5% 9.1% -2.0% 4.9% 6.9% Reserve & Surplus Gross profit 20.9% 18.0% 12.0% 27.6% 22.6% Money received against warrants EBITDA 19.3% 11.1% 7.4% 13.7% 31.5% Networth EBIT 18.3% 17.5% 1.0% 7.5% 33.5% Borrowings PBT 16.1% 21.2% 0.1% 17.1% 58.6% Long term provisions PAT 14.9% 4.2% 0.1% 17.1% 58.6% Trade paybles EPS 6.7% 1.8% 0.1% 17.1% 58.6% Other current liabilities Margin Short term provisions Gross profit margin 8.7% 9.4% 10.8% 13.1% 15.0% TOTAL EBITDA margin 6.0% 6.1% 6.6% 7.2% 8.9% Fixed assets EBIT margin 5.7% 6.2% 6.3% 6.5% 8.1% Long term loans and advances PAT margin 2.8% 2.7% 2.8% 3.1% 4.6% Other non current assets Operating efficiency Deffered tax assets (net) RoE 30.5% 22.7% 18.3% 17.9% 23.1% Current assets RoCE 19.6% 18.5% 16.7% 17.8% 24.3% - Inventories Fixed asset turnover Trade receivables Working capital turnover Cash and cash equivalents Working capital cycle (days) Short term loans and advances Financial leverage - Other current assets Interest exp / EBITDA 40.1% 40.5% 38.5% 31.6% 20.8% TOTAL Debt / Equity (x) Net Debt / Equity (x) Per share data & valuation EPS Growth in EPS 6.7% 1.8% 0.1% 17.1% 58.6% BVPS PE (x) PB (x) EV/EBITDA (X) Source: Nirmal Bang PCG Research 11 P a g e

12 Disclaimer Nirmal Bang Securities Private Limited (hereinafter referred to as NBSPL )is a registered Member of National Stock Exchange of India Limited, Bombay Stock Exchange Limited and MCX stock Exchange Limited. We have been granted certificate of Registration as a Research Analyst with SEBI, Registration no. is INH for the period to NBSPL or its associates including its relatives/analyst do not hold any financial interest/beneficial ownership of more than 1% in the company covered by Analyst. NBSPL or its associates/analyst has not received any compensation from the company covered by Analyst during the past twelve months. NBSPL /analyst has not served as an officer, director or employee of company covered by Analyst and has not been engaged in market making activity of the company covered by Analyst. The views expressed are based solely on information available publicly and believed to be true. Investors are advised to independently evaluate the market conditions/risks involved before making any investment decision. 12 P a g e